Buy high and sell low

Translation: Original article published in Finnish on 9/19/2024 at 7:45 am EEST.

Buy low and sell high is the most overused phrase in the investment world. Theoretically, a strategy based on this phrase is probably one of the best investment strategies in hindsight, but often the cheap or expensive nature of a stock or investment can only be determined after the fact. Typically, a stock is considered cheap when it has low valuation multiples and expensive when it has high valuation multiples. But a cheap valuation at the time of investment does not necessarily mean that the stock was ultimately cheap, and vice versa.

With this idea in mind, we set out to determine how well low-valued stocks have performed versus high-valued stocks. We examined stocks on Nasdaq Helsinki and used the most general valuation multiple, the P/E ratio, as a measure of cheapness/expensiveness. For this experiment, we chose one-year forward-looking valuation multiples because we believe they better reflect the valuation and expectations of the stock than backward-looking actual multiples. We looked at two time periods, 2019–2023 and 2011–2015. We selected the top 10% most expensive and cheapest stocks at the end of both 2010 and 2018, using one-year forward-looking P/E ratios. In the end, the results offer something for everyone and depend on the environment and the profile of the companies.

A mixed bag of results

In the period from early 2011 to the end of 2015, in the aftermath of the financial crisis, stocks with the cheapest valuations outperformed stocks with more expensive valuations. The cheapest stocks (top 10%) generated a total return of up to 46% over the five-year period, while the most expensive stocks in terms of valuation (top 10%) ended up with a loss of 53% over the period. The difference in returns was thus quite significant. 

The market environment was weak at the time, and cheap stocks seem to have been genuinely cheap. However, between 2011 and 2014, stocks did not return very much, and most of the returns can be explained by the bull market that started in 2015 (cheap cyclicals took off) and the buyouts that occurred in this group of stocks (Okmetic 2016). But for the most part, stocks with expensive valuations were also truly expensive at the beginning of 2011. In mid-2012, the stocks plunged by more than 50% and did not recover significantly in the end.

However, over the 2019-2023 period, stocks with expensive valuations outperformed stocks with cheap valuations. Over this period of both bull and bear markets, highly valued stocks rose by up to 80%, while low-valued stocks fell by as much as 64%. At the peak in 2021, highly valued stocks had returned almost 300% and the basket of lower valued stocks was still almost unchanged. Between 2022 and 2023, both saw significant declines, but the recession and company-specific difficulties caused some of the "cheap" stocks to plummet by almost 100%.

Returns vary by time period and profile

With a small sample size and an arbitrary time horizon, returns have been mixed and it cannot be directly said that the stocks with expensive valuations or the stocks with cheap valuations are significantly better than the other. This is a topic that requires more research and, in our opinion, a slightly stricter criteria for stocks.

However, based on these observations, we can see that the expensive stocks in the period from 2019 onwards were largely companies with growth expectations, which explains their excess returns over the selected period. In contrast, the stocks selected for the expensive basket in 2011-2015 were troubled companies with poor earnings levels in the aftermath of the financial crisis, which explains the very clear underperformance.

The stocks with the cheapest P/E at the end of 2010 were in turn cyclical companies that had been in decline for several years and where the market did not believe in an earnings or economic turnaround. Although the companies did not turn around immediately, the bottom was eventually found and the basket was finally saved by a single takeover bid (Okmetic 2016). Without this offer, the cheap stocks would have generated returns of only a few percent. Between 2019 and 2023, stocks with a cheap P/E were cheap for a reason and declined sharply over the period. The stocks were often turnaround or problem companies, and the market was skeptical about their performance. The list also included many cyclical companies that have performed very poorly, especially after 2021.

As a general observation, the return potential of investing in high- or low-value companies depends largely on the time period in which you invest. At the cusp of an upswing, when valuation multiples are rising, growth companies with high valuations are understandably a good investment. On the other hand, in a downturn and when stock market sentiment is anemic, a high valuation may not tell you much about a stock's return potential.

We also believe that a stock's profile plays a significant role in the equation. If we were to select growth companies loaded with high expectations in the basket of "expensive" stocks and exclude turnaround or problem companies, the returns could already look very different. An interesting way to look at this issue would be to examine the starting points of overperforming and underperforming stocks in terms of valuation and expectations before the price of the stock changes significantly.